Saving for College-the Best 529 Plans

Most financial professionals would advise not to sacrifice your retirement savings in order to save for your kids’ education (or more education for you)–especially when there are scholarships and loans available for college, and not for retirement. But as a mother, I understand the sense of responsibility many parents feel to make education a top priority. My parents never wanted cost and potential debt to be a deterrent to me or my brother when it came to higher education and I want the same for my kids.

On the other hand, I also appreciate the idea of kids having more motivation to work hard if they have to pay for school themselves. So, I think an equitable combination of funding from parents, scholarships (if possible) and loans could be ideal. The challenge is that college costs continue to soar, regularly outpacing the average annual inflation rate in the U.S. by nearly twice as much. So, unless your kid chooses a budget-friendly state school or is academically gifted and manages to get a generous scholarship, the amount you need to save and they need to borrow could be steep.

529 plans are one of the best ways to maximize college savings, and one of the most popular college savings vehicles. They can offer tax-free growth, federal and state tax advantages, and have less of an impact on financial aid than other types of savings and investment accounts. But 529 plans are not perfect and not all plans are created equal. There are also 105 different plans to choose from today.

To help you navigate your options and pick the right plan, here are the top 10 things you need to know.

What You Need to Know

529 plans are one of the best ways to maximize college savings, and one of the most popular college savings vehicles. They can offer tax-free growth, federal and state tax advantages, and have less of an impact on financial aid than other types of savings and investment accounts. But 529 plans are not perfect and not all plans are created equal. There are also 105 different plans to choose from today.

To help you navigate your options and pick the right plan, here are the top 10 things you need to know. Most financial professionals would advise not to sacrifice your retirement savings in order to save for your kids’ education (or more education for you)–especially when there are scholarships and loans available for college, and not for retirement. But as a mother, I understand the sense of responsibility many parents feel to make education a top priority. My parents never wanted cost and potential debt to be a deterrent to me or my brother when it came to higher education and I want the same for my kids.

On the other hand, I also appreciate the idea of kids having more motivation to work hard if they have to pay for school themselves. So, I think an equitable combination of funding from parents, scholarships (if possible) and loans could be ideal. The challenge is that college costs continue to soar, regularly outpacing the average annual inflation rate in the U.S. by nearly twice as much. So, unless your kid chooses a budget-friendly state school or is academically gifted and manages to get a generous scholarship, the amount you need to save and they need to borrow could be steep.

There are two types of 529 plans.

529 plans are usually categorized as either prepaid or savings plans.

Savings plans work much like a 401K or IRA by investing your contributions in mutual funds or similar investments you choose from a predetermined selection. The money in your account can grow and be withdrawn tax-free if used for qualified higher education expenses, and your account value will go up or down based on the performance of the particular options you select. Nearly every state now offers a 529 savings plan option. Investment options and costs vary by plan.

Prepaid plans allow you to prepay all or part of the costs of an in-state public college education, but can also be converted for use at private and out-of-state colleges. The main feature of prepaid plans is that you can lock in college costs at today’s prices and performance is typically tied to tuition inflation rates. There are three types of prepaid plans: contract, unit and voucher. Currently, only 18 states offer 529 prepaid plans and not all types are offered by each state. Educational institutions can offer their own 529 prepaid plan, but the Private College (aka “Independent”) 529 Plan, which is a prepaid plan specifically for private colleges, is the only institution-sponsored 529 plan so far.

Prepaid plans are NOT worry-free.

529 prepaid plans may sound great and aren’t subject to market ups and downs like 529 savings plans, but the reality is that they may not cover all costs when the time comes. While prepaid plans were historically backed by a guarantee from the state, not all are today, since ballooning tuition rates have made it very difficult for some states to keep up. Keep in mind that a state’s guarantee is only as good as its financial stability.

If your child chooses to go to a private or out-of-state school, the state does not have to guarantee tuition coverage (in that case you might get credited up to a certain amount or have your contributions refunded). If you are interested in a prepaid plan, you should seriously consider your child’s likelihood of going to a particular school. Also, before opening an account, make sure to inquire about a state-backed guarantee and what happens if tuition prices increase sharply, research the plan’s historic performance and stability, and understand what the plan covers (some plans do not cover room and board).

Pay attention to pricing.

Prepaid plans build their fees into their required payments so they are harder to extrapolate, but know that most plans charge a high premium due to the risk they take on by allowing you to lock in college costs at today’s prices and could cost more than 529 savings plans. Some plans also charge administration fees so watch out for that.

When it comes to 529 savings plans, there are two types: direct-sold and broker-sold. As you can probably guess, direct-sold plans, which are sold directly to the public by the states, are almost always cheaper than buying through a broker who wants to earn a commission. According to Morningstar, broker-sold investment options cost an average of 1.47 percent versus an average of 0.54 percent for options offered in direct-sold plans.

Even among direct-sold plans, costs can vary widely. The cheapest 529 savings plans are offered by Louisiana, Rhode Island and South Carolina. The catch is that you have to be residents of those states. The cheapest plans where you don’t have to be a resident are those offered by Ohio, Wisconsin, New York and California. Some of the most expensive plans are those offered by Hawaii, District of Columbia, Nevada, North Dakota and Montana. The Saving for College site lets you compare costs of direct-sold plans by state.

Your 529 savings plan has risks.

When you invest in a 529 plan you are investing in mutual funds and other securities that could lose value. There are generally several investment options for you to choose from in 529 plans (the more options the better), which can range from ultra-conservative certificates of deposit (CDs), money market funds and bonds to very aggressive growth and international stock funds.

It is important to select investments that fit your time horizon and tolerance for risk. And remember that you are investing for your kid, not yourself. The trick is to invest in a variety of investments and create a well-diversified portfolio that can take advantage of market upswings, but also help protect you from significant losses when the market drops. To make it easier for parents to choose appropriate investments, many plans now offer target-date funds with a preselected asset allocation (based on when your child is expected to begin college) that becomes more conservative as the child gets older.

Keep in mind, though, that target-date funds can still lose significant value and their historical performance should be carefully considered. They also tend to cost more than other plan investments because of their convenience and active management. You can compare plan performance on the Saving for College site as of the end of this June, and also explore individual plan investment options.

Target-date funds vary—and so do risk levels.

Target-date funds are quickly becoming the most popular investment option in 529 savings plans because of their ease and one-stop-shopping nature. But even though these age-based funds automatically shift from aggressive to conservative as the child approaches college age, they might not shift as quickly as you would like and your child’s account could lose significant value if the market has a bad year or few.

Before investing, it is important that you compare target-date funds from different plans, examine their historical performance and understand how their allocations change over time. The rate at which target-date fund allocations shift varies among 529 plans. So, to make sure that your child’s portfolio is keeping up with your savings needs and performance expectations, you should check in periodically. If your plan is disappointing, you can consider changing funds, which the Internal Revenue Service (IRS) allows families to do once per year.

Your home state plan may not offer the best deal.

While all 529 plans come with federal tax advantages, certain states also offer state income tax deductions and/or credits and matching contributions in some cases. For example, Indiana offers a tax credit of up to $1,000 per year against state income tax. Meanwhile, Alabama, Arkansas, New York and North Dakota offer annual state tax deductions of up to $5,000 for single filers and $10,000 for married couples. In Mississippi the deduction can be as much as $20,000 and in Pennsylvania, the deduction can be as much as the annual gift tax exclusion ($28,000 for married couples in 2013).

A few states, such as Colorado, Kansas, Maine, Missouri and West Virginia, also offer matching grant programs that match a certain amount of a family’s contributions, which may depend on their income level. Pennsylvania, Kansas and Arizona offer state tax deductions for contributions to any 529 savings plan, not just their own. While incentives like these can provide extra motivation to invest in your home state’s plan, you should still compare the costs and performance history of different plans to help you determine whether or not it is worth investing out-of-state. Click here to compare plans based on specific features including taxes and other benefits.

The impact of 529s on financial aid is relatively minimal.

A 529 account owned by a parent for a dependent student is reported on the federal financial aid application (FAFSA) as a parental asset, which is assessed at a maximum 5.64% rate in determining the student’s Expected Family Contribution (EFC). Since the 2009-2010 school year, student-owned 529 plans are also to be reported as parental assets, if the student files the FAFSA as a dependent and has to include parent assets and income. This is good news as the parental rate of 5.64 percent is considerably less than the 20 percent rate on non-529 assets owned by the student (such as savings accounts, individual securities, investment accounts and traditional IRAs).

Along with favorable asset treatment, a 529 account also gets a break when it comes to the income portion of the financial aid eligibility formula. A tax-free distribution from a 529 plan to pay college expenses in the current year is not considered to be part of the “base-year income” that reduces next year’s financial aid eligibility. Keep in mind that the value of 529 assets owned by a grandparent (or other non-parent) is not reportable on the FAFSA, but distributions are included as student income and can significantly affect financial aid — unless they are made in the last year of school. It is important to remember that the federal financial aid rules are subject to frequent change and that 529 assets might affect your child’s ability to receive rewards from a particular school or government aid if they have special needs.

529 plans are transferrable.

In the event your child decides not to attend college or vocational school, attends an international university without a federal school code, or receives a generous scholarship, you can easily transfer the 529 plan account to a new beneficiary who is directly related to your kid (including siblings, cousins, step-relatives, in-laws or even you or their other parent). Financial advisors generally recommend opening a 529 account for each child rather than just having one for multiple children because of the greater tax benefits, importance of tailoring the investments to an individual age, and potential financial aid implications.

If, for whatever reason, you end up with unused funds in a 529 plan, you can almost always roll them over to another 529 plan without penalty. In the event you withdraw 529 funds for something other than qualified education expenses, you will pay a 10 percent penalty and owe income taxes on the amount of earnings taken for that year (distributions are allocated between principal and earnings on a pro-rata basis). An exception to the penalty can be claimed if the account is terminated because the beneficiary died or became disabled, or if she or he has received a scholarship.

Grandparents can benefit from 529 plans.

Besides the emotional reward of giving the gift of education to a grandchild, grandparents can benefit from significant tax breaks by contributing to a 529 plan. Contributions qualify for the $14,000 annual gift tax exclusion and up to $70,000 can be contributed per beneficiary at once and sheltered over a five calendar-year period from gift taxes, as long as no additional contributions are made during that period. If a grandparent owns the 529 account, those contributions and subsequent earnings are removed from their estate, reducing their potential estate tax liability.

Depending on their state of residence, they can also benefit from state income tax deductions. Another bonus for grandparents who own and contribute to a 529 is that they not only get the gifting benefit, but they can also maintain control of the assets and make the investment decisions. Parents love it when grandparents own the 529 account because those funds do not impact financial aid (however withdrawals can if taken earlier than the last year of college).

Broker-sold plans may make sense.

If you’re already working with a financial advisor you trust, it can make sense to open a 529 account through her or him. Your advisor should have a good idea of your family’s financial situation and goals and can help you pick a plan and investment portfolio that is suitable. Plus, they can monitor the account and make recommendations for changes as they see fit. For some people, this personalized guidance and active management may be worth the extra cost.

Broker-sold 529 plans can offer mutual funds with as many as five different “share classes,” each with a different cost structure. “A” shares usually have the highest upfront cost, with a sales charge of as much as 5.75 percent on each investment, but also have the lowest ongoing annual expenses. “C” shares have no upfront sales charge, however, they incur higher annual expenses that over a few years can add up to be greater than the A-share sales load. Choosing C shares can make sense if your child is older and has a shorter investment horizon. Your financial advisor should explain all of the potential fees, including fund expenses, commissions and administrative costs, before you open the account. Be sure to ask about the availability of a reduced A-share sales charge if your account balance reaches certain “breakpoints.”

In some 529 plans, your eligibility for breakpoint pricing will be based on the total amount invested with a particular mutual fund family inside and outside a 529 plan, such as in a brokerage account or IRA. Also, many 529 plans will waive the A-share sales load entirely if you are purchasing the plan through a fee-based financial planner rather than a commission-based broker. This is fair, considering that fee-based planners charge their own fees based on assets under management or on an hourly rate. The Arkansas iShares 529 Plan is sold exclusively through fee-based planners, which means investors would not pay any sales charges. Click here to compare broker-sold plans by state.